The 2008 Financial Crisis stemmed from a perfect storm of factors. Subprime mortgages, complex financial instruments, and risky behavior by banks all played a role. The housing bubble burst, triggering a chain reaction that exposed deep vulnerabilities in the financial system.
Loose monetary policy and conflicts of interest at credit rating agencies added fuel to the fire. As the crisis unfolded, it became clear that systemic issues and regulatory failures had allowed risks to build up unchecked throughout the economy.
Subprime Mortgages and the Crisis
Characteristics and Expansion of Subprime Lending
- Subprime mortgages target borrowers with poor credit histories featuring higher interest rates and unfavorable terms
- Expansion of subprime lending in early 2000s driven by rising home prices and relaxed lending standards created housing bubble
- Originate-to-distribute model incentivized lenders to issue mortgages without proper credit assessment as risk transferred to investors
- Housing price decline and interest rate increase led to widespread subprime borrower defaults causing ripple effects
Securitization and Complex Financial Instruments
- Securitization pools various debt instruments sold as securities to investors spreading mortgage risk throughout financial system
- Key financial instruments contributing to crisis included mortgage-backed securities (MBS) and collateralized debt obligations (CDOs)
- Complexity and opacity of securitized products hindered accurate risk assessment by investors and regulators
- Examples of securitized products (residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS))
Risk-Taking and Market Stability
Risky Behavior and Regulatory Changes
- Financial institutions pursued higher returns through complex financial instruments and excessive leverage
- Repeal of Glass-Steagall Act in 1999 allowed commercial banks to engage in investment banking activities blurring lines between traditional and riskier practices
- "Too big to fail" mentality encouraged moral hazard as large institutions expected government bailouts
- Examples of risky financial practices (credit default swaps (CDS), synthetic CDOs)
Systemic Vulnerabilities
- Heavy reliance on short-term funding sources like repo market increased vulnerability to liquidity crunches
- Off-balance-sheet vehicles such as structured investment vehicles (SIVs) allowed banks to hide risky assets and evade regulatory capital requirements
- Interconnectedness of financial institutions through complex transactions amplified systemic risk
- Failure of major institutions (Lehman Brothers, Bear Stearns) triggered domino effect throughout global financial system
Credit Rating Agencies and Conflicts
Role and Business Model of Rating Agencies
- Credit rating agencies evaluate creditworthiness of financial instruments and institutions providing ratings for investor decision-making
- "Issuer pays" model created potential conflicts of interest and incentives for inflated ratings
- Oligopolistic industry structure dominated by three major agencies (Moody's, Standard & Poor's, Fitch) limited competition
- Examples of rating categories (AAA, AA, A, BBB)
Impact on Financial Crisis
- Complex financial instruments received high ratings despite underlying risks giving investors false sense of security
- Regulatory reliance on credit ratings for determining capital requirements amplified impact of potentially inaccurate ratings
- Slow response in downgrading securities during crisis exacerbated market instability and investor panic
- Post-crisis reforms aimed to address conflicts of interest and improve transparency and accountability of rating agencies
Loose Monetary Policy and the Crisis
Federal Reserve Policy and Economic Environment
- Federal Reserve maintained low interest rates after dot-com bubble burst and 9/11 attacks to stimulate growth and prevent deflation
- Low rates encouraged excessive borrowing and risk-taking particularly in housing market with popularity of adjustable-rate mortgages
- "Greenspan put" perception of Federal Reserve market intervention encouraged risk-taking and moral hazard
- Global imbalances including large capital inflows from emerging economies contributed to low long-term interest rates
Consequences and Policy Debates
- Abundance of cheap credit fueled asset bubbles particularly in real estate as investors sought higher yields
- Taylor Rule monetary policy guideline suggested interest rates kept too low for too long exacerbating economic imbalances
- Sudden monetary policy tightening and rising interest rates in 2004-2006 contributed to housing bubble burst
- Examples of Federal Reserve interest rate changes (Federal funds rate target lowered to 1% in June 2003, raised to 5.25% by June 2006)